THE END OF THE REVOLUTION IN PARTNERSHIP TAX?

THE END OF THE REVOLUTION

IN PARTNERSHIP TAX?

Mark P. Gergen*

Aquiet intellectual revolution has taken place in partnership taxAover the last quarter century. As in most intellectual revolutionsin the law, old ideas were elaborated into a new system to ad-

dress particular anomalies within the field. Once the system took hold onpeople's minds it changed the terms of analysis across the entire field.The system is best known by the name capital accounts analysis. It alsohas been called the deferred sale approach,1 which is less grand but getsat an important feature. Key elements in the system were laid in the late1970s and early 1980s to get a handle on special allocations. The systemflourished in the late 1980s and 1990s because it helped address two sig-nificant areas of trouble in those years, shifting tax attributes and dis-guised sales.

The system is a way to take apart a partnership to identify each part-ner's tax interest in each asset while connecting this to his economic inter-est in the partnership. Think of a partnership as a pot. When an asset isput into the pot it is valued and the contributor is given a claim on thepot-his capital account-for that amount. The contributor does not rec-ognize gain or loss, but instead a tag is put on the asset to record that hehas an interest in so much deferred tax gain or loss on the asset. He willrecognize this deferred tax amount when the asset is sold, as it is used up,or perhaps when the asset leaves the pot. The opposite is done when apartner takes an asset out of the pot. The value of the asset he takes issubtracted from his claim on the pot and, if the partner has no other claimon the pot, then his deferred tax amounts on other assets in the pot areadded up and attached to the asset he takes out (assuming the assets areof the same character).

Professor Lokken aptly describes this revolution as a victory of an ag-gregate theory over an entity theory of partnership tax. A hallmark ofthe revolution is a change in how we think about partnership basis. Theold way of thinking focused on curing discrepencies between inside andoutside basis. The new way of thinking focuses on tagging a partner withhis deferred tax gain or loss. Another hallmark of the revolution is to

* Joseph C. Hutcheson Professor in Law, The University of Texas School of Law,Austin, Texas.

1. Laura E. Cunningham & Noel B. Cunningham, Simplifying Subchapter K: The De-ferred Sale Method, 51 SMU L. REV. 1 (1997).

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look to provisions on capital accounts in the partnership agreement todetermine partnership economics.

Part I makes the case for my claim that there has been an intellectualrevolution in the field and fills out the description of the system. Part IIexplains that there is still useful work to be done in elaborating the sys-tem. The system can help solve two enduring problems in partnershiptax, preventing shifts in the character of income on distributions andidentifying partnership compensation. Part III explores the anomalies inthe system. It is well known that the system's weakness lies in the factthat a capital account can be a poor measure of a partner's economicinterest in a partnership. This usually is associated with special alloca-tions and guaranteed payments. Two phenomena that are just now get-ting attention-discounts in the value of a partnership interest andoptions (and side agreements more generally)-will put further strain onthe system because they further cloud the relationship between capitalaccounts and partnership economics. My sense is that these anomalies inthe system do not justify junking it just yet. Recent problems in sub-chapter K involve exploiting gaps in the system of capital accounts analy-sis and can be addressed within the system.2 But the system is in forrough times.

One change is necessary if we are to maintain the present system.While capital accounts analysis is workable as a conceptual system-it isfairly easy to use, becoming almost intuitive once you get your mindaround it, and it does a fairly good job of connecting tax and economicincome (that is until you have to deal with options, discounts, guaranteedpayments, special allocations, and other things that can make payoffs in-dependent of capital accounts)-the system has a serious practical prob-lem. It assumes that people write and abide by formal partnershipagreements and it requires that they collect and retain a fair amount ofinformation. I know from personal experience that accountants in familypartnerships often do not demand asset revaluations and do not do capi-tal account adjustments that are required by partnership agreements,even when there are real economic consequences to partners.3 It is un-realistic to expect accountants to do this to satisfy the taxman.

Professor George Yin has proposed a solution to the practical prob-

2. Lawrence Lokken, Taxation of Private Business Firms: Imagining a Future WithoutSubchapter K, 4 FLA. TAX REV. 249 (1999), argues that we should abolish subchapter Kbecause it is so complicated as to be unworkable. He would limit flow-through taxation toservice partnerships on the basic lines of current subchapter K and deny it to capital inten-sive partnerships. This essay may be considered an answer to Lokken's thoughtful critique,which I take to be conceptual in nature. My argument is that beneath the surface complex-ity of subchapter K is a simple conceptual system for taxing capital-intensive partnershipsthat is just coming into focus. Jeffrey L. Kwall, Taxing Private Enterprise in the New Mil-lennium, 51 TAX LAW. 229 (1998), proposes abolishing subchapter K and leaving firms withthe choice between a simple capital structure to be taxed under subchapter S (with sometweaking) or an entity level tax.

3. This is likely to be a rich source of civil litigation in coming years. Accountantsand lawyers who fail to make these adjustments should fear claims for breach of fiduciaryduty by partners who are disadvantaged.

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lem.4 He proposes the creation of a simplified pass-through regime-callit K-lite-along the lines of current subchapter S. Entities that opt forthis regime would be excused from the rigmarole of valuing assets when-ever sharing ratios change, as well as, tagging assets with deferred taxamounts, and keeping track of the tags. Reasonable minds may differ onthe details of what people must give up to get simple pass-through rules.Yin would limit K-lite to entities owned by U.S. individuals, allow onlythe simplest type of special allocations, and give up non-recognition ondistributions. Whatever its precise contours, once K-lite is available, wemay demand more from entities that opt for the freedom of K-heavy.Compliance can be improved with simple, practical measures, such as re-quiring that a partnership return be signed by a certified person, presum-ably an accountant, who would attest that he made the necessaryinquiries about asset values and sharing ratios and the necessary adjust-ments to tag partners with deferred tax amounts.

I. THE REVOLUTION

Much of capital accounts analysis follows straight from basic principlesof business law and tax law. It is basic business law that a partner iscredited for the value of what he puts into the partnership pot and deb-ited for the value of what he takes out.5 It is basic tax law that unrecog-nized gain or loss is deferred to be recognized at a future time. It also isbasic tax law that if partnership gain or loss is allocated to a partner fortax purposes, he gets the economic income or loss through a credit ordebit to his capital account. The breakthrough in the system lies in asso-ciating deferred gain or loss with specific assets. Again, it is useful tothink of each asset carrying tags that identify each partner's deferred taxamount on the asset.6

4. George K. Yin, The Future Taxation of Private Business Firms, 4 FLA. TAX REV.141 (1999). Professor Yin was a reporter on an ALI project on pass-through entities thatmade a similar proposal. ALl, FED. INCOME TAX PROJECT: TAXATION OF PRIVATE Busi-NESS ENTERPRISES, REPORTERS' STUDY (George K. Yin & David J. Shakow rptrs., July1999).

5. Bracken v. Means, 631 So. 2d 178 (Miss. 1994) (holding that additional contribu-tions had to be added to capital account and reimbursed on liquidation); Langness v. 0 St.Carpet Shop, Inc., 353 N.W.2d 709 (Neb. 1984) (holding that service partner who contrib-uted no capital has no claim on capital).

6. In theory, a depreciable or amortizable asset can look like a pom-pom with a newstreamer added for each partner on each revaluation. Each streamer is treated as a mini-asset that is depreciated for book purposes over its own hypothetical useful life beginningfrom the revaluation that produced the streamer. I say "in theory" because the regulationsmake this method elective unless not using it would be abusive. This comes from the§ 704(c) regulations. This is required under the remedial allocation method. When a de-preciable asset with built-in gain (value in excess of basis) is contributed to a partnership,the gain is treated as a separate asset put in service at that time. Treas. Reg. § 1.704-3(d)(2) (as amended in 1997). This is not required under the traditional method and thetraditional method with curative allocations. Treas. Reg. § 1.704-3(b)(2), Example 1(ii) (asamended in 1997); Treas. Reg. § 1.704-3(c)(4), Example 1 (as amended in 1997). The tradi-tional method is problematic in the case of an asset with a short remaining tax life becauseof the convention that deferred tax gain is written off at the same rate as the tax basis of anasset. The regulations give as an example of a case where use of the traditional method is

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An example is tedious but useful.Example: K and L each invest $10,000 in a partnership as equal part-ners. The partnership buys securities for $20,000. These increase invalue to $50,000 when M contributes $25,000 for a one-third interestin the partnership. The partnership restates the capital accounts of Kand L to $25,000 and it restates the book value of the securities to$50,000. K and L each are tagged with $15,000 deferred tax gain onthe securities. Later the securities are sold for $74,000. Each partnertakes $8,000 of the $24,000 book gain. The $54,000 tax gain is allo-cated $23,000 each to K and L and $8,000 to M.

Older readers will recognize this as example (4) from the pre-1983§ 704(b) regulations. This example used to give people trouble. In his1971 treatise, Willis worried that nowhere in the example did it say thatthe partnership agreement provided for the allocation of the pre-admis-sion gain to K and L.7 He concluded that "the act of the partners inincreasing the amount at which the securities are carried on the partner-ship's accounting record and the agreement to share profits" is equivalentto an amendment of the partnership agreement. 8 In an insightful 1977article, Sherwin Kamin concluded that "the regulations reach the correctresult" because they "give[ ] the taxable gain to the persons who are re-ceiving the economic benefit."9 He criticized the regulation for sayingthat the allocation of the tax gain had an economic effect. Kamin pointedout that this conflates the decision to increase the capital accounts of Kand L on the admission of M (which does have an economic effect) andthe decision to allocate the pre-admission tax gain to K and L (whichdoes not). 10 Today we think of these steps as interdependent parts of asystem that connects tax and economics in a partnership through the capi-tal account. While this is some evidence of a change in thinking, there isbetter evidence in the analysis of more technical issues, to which I willcome.

If anyone deserves to be called father of the revolution in subchapterK, it is William McKee." The revolution's seminal legal text is the§ 704(b) regulations, which were issued in preliminary form in 1983 andfinalized in 1985. McKee, then at the Treasury, was the principal author.The § 704(b) regulations require partnerships to maintain capital ac-counts and to respect these accounts on liquidation by dividing assets

abusive a case where an asset worth $10,000 with a $1,000 basis and one year remaining inits useful life is contributed to a partnership to exploit the quick write-off of the deferredtax gain. Treas. Reg. § 1.704-3(b)(2), Example 2(ii) (as amended in 1997); Treas. Reg.§ 1.704-3(c)(4), Example 3 (as amended in 1997).

7. Id. at 212.8. ARTHUR B. WILLIS, WILLIS ON PARTNERSHIP TAXATION § 19.07 (1st ed. 1971).

The only change in the second edition, published in 1976, is to note the analogy to § 704(c).9. Sherwin Kamin, Partnership Income and Loss Allocations Before and After the Tax

Reform Act of 1976, 30 TAX LAW. 667, 673 (1977).10. Id. at 672-73.11. McKee went on to King & Spaulding in 1983 and in 1999 moved to McKee, Nel-

son, Ernst & Young.

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based on capital account balances. 12 The regulations do not strictly re-quire revaluation of assets and adjustment of capital accounts when inter-ests shift (the old KLM example), but they strongly warn against failingto make these adjustments. 13 In any event, the mandatory rules on main-taining and respecting capital accounts ensure that K and L cannot reapthe $30,000 gain without taking it into income. Professionally draftedpartnership agreements routinely require revaluations and adjustments. 14

The roots of McKee's system lay further back. The first edition of theMcKee treatise, published in 1977, used capital account analysis as thetouchstone for the validity of special allocations. Three years earlier Mc-Kee-then a Professor at the University of Virginia School of Law-usedcapital accounts to analyze partnership allocations in debt-financed realestate ventures.' 5 McKee properly credited others for recognizing "thatthe presence or absence of substantial economic effect can be determinedby the analysis of the effect of the special allocation on the partner's capi-tal accounts." 16 McKee's contribution turned what had been a factor tobe considered in evaluating special allocations into a system of analysiswith implications that reach far beyond the problem of specialallocations.

Many of the changes in subchapter K over the last twenty years can beunderstood as working the system out. Most of these changes preventshifting tax attributes among partners or limit the ability to use a partner-ship to exchange assets tax-free, two areas of particular trouble in the late1980s and 1990s. Shifting tax attributes among partners hardly is a newproblem, the authors of the partnership rules in the 1954 Code were wellaware of it.17 They addressed the problem through elective rules in

12. Treas. Reg. § 1.704-1 (as amended in 1999).13. Treas. Reg. § 1.704-1(b)(2)(iv)(f) (as amended in 1999) (flush paragraph at end

warning that if capital accounts are not adjusted, the anti-abuse principles in subsections(b)(1)(iii) and (b)(1)(iv) should be consulted). Example 14 is the same facts as the oldKLM example. It concludes that if the securities are not booked up on the admission ofthe new partner, the gain must be allocated to the old partners under the general anti-abuse principles.

14. Revaluation of assets and adjustment of capital accounts is necessary on economicgrounds when the partnership agreement provides for the allocation of gain and loss basedon relative capital accounts. This is customary in capital intensive partnerships. Failure torevalue assets and adjust capital accounts will result in a shift of wealth among partners. Inthe KLM example, if the partnership agreement allocates gain and loss based on capitalaccount balances and the book value of the securities and the amount in K and L's capitalaccounts are not increased on the admission of M, then M will take twenty-five fifty-fifthsof $54,000 instead of $8,000 at the end of the day.

15. William S. McKee, Partnership Allocations in Real Estate Ventures: Crane, Kresserand Orrisch, 30 TAX L. REV. 1 (1974).

16. WILLIAM S. MCKEE ET AL., FEDERAL TAXATION OF PARTNERSHIPS AND PART-NERS $ 10.02[2] (1st ed. 1977) ("The [§ 704(b)] Regulations neither define the [substantialeconomic effect] test in theoretical terms, nor explicate the manner in which it has beenapplied. However, most commentators believe, and the staff of the Joint Committee onTaxation has stated, that the presence or absence of substantial economic effect can bedetermined by the analysis of the effect of the special allocation on the partner's capitalaccounts."). See also McKee, supra note 15, at 10 n.18, 18.

17. The classic texts are J. Paul Jackson et al., A Proposed Revision of the FederalIncome Tax Treatment of Partnerships and Partners-American Law Institute Draft, 9 TAX L.

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§ 704(c) for handing pre-contribution gain or loss and elective rules in§§ 734 and 743 for handling basis adjustments on distributions and trans-fers of interests. Only the hot asset rules in § 751 were mandatory.

The authors of the 1954 Code took a laissez faire approach to the prob-lem of shifting tax attributes because they thought the costs of complexityin the solution outweighed the gains in accuracy. Their premise was:

Most of the problems encountered in the partnership area are con-cerned with the distribution of the burden of taxation among themembers of the group. Since the Treasury from the standpoint of taxpolicy is not greatly concerned with this allocation, the issues are es-sentially not between Treasury and taxpayer-partner but betweenpartner and partner.' 8

We have learned that shifting tax attributes among partners is verymuch a problem for Treasury. The authors of the 1954 Code were lesssensitive to timing issues than are we who experienced the high-interestrates of the 1970s and 1980s. Often when tax attributes shift the tax bene-fit is temporary because there is a later offsetting tax detriment that setsthings right. The authors of the 1954 Code also had in mind a world inwhich partners tended to be high income individuals. We are accustomedto tax shelter promoters bringing together persons with different taxprofiles in a partnership to exploit the difference.

Reversing the laissez faire policy of 1954, § 704(c)(1)(A), enacted in1984, makes mandatory the allocation of pre-contribution gain or loss tothe contributing partner if an asset bearing such gain or loss is sold ordepreciated. The § 704(b) regulations (1985) push partners to make whatare called "reverse 704(c) allocations." This means the allocation is madeto the appropriate partner of gain or loss that accrues within a partner-ship when interests in the partnership change (the trigger in the regula-tions is a non pro rata contribution or distribution). 19 This is our oldfriend the KLM example. Regulations implementing § 704(c), finalizedin 1993, include the remedial allocative method 20 as an option. This is atheoretically correct method for handling pre-contribution gain or lossunder capital accounts analysis, and implicitly is the benchmark for deter-mining if two other simpler methods can be used.21

REV. 109 (1953) [hereinafter Proposed Revision], and J. Paul Jackson et al., The InternalRevenue Code of 1954: Partnerships, 54 COLUM. L. REV. 1183 (1954). What the authorscall the "credited value or deferred sale approach" for dealing with contributed property isbasically modern capital accounts analysis. The authors rejected it because they thought ittoo complex for taxpayers or agents in the field. McKee, supra note 15, at 120-23. Theauthors did not carry forward the approach to distributions and sales of interests. Myguess is that they foresaw the possibilities but chose not to pursue them because they hadrejected the approach in the easiest case.

18. Proposed Revision, supra note 17, at 112.19. Treas. Reg. § 1.704-1(b)(2)(iv)(f)(4) (as amended in 1997).20. Treas. Reg. § 1.704-3(d)(1) (as amended in 1997).21. The regulations require use of the remedial allocation method when use of the

other methods would be abusive. See supra note 6.

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Current legislative proposals aimed at loss duplication extend the sys-tem a bit further. The proposals respond to a spate of loss-duplication taxshelters in which a taxpayer contributes a loss asset to a partnership andthen exits from the partnership leaving the built-in loss for other partnersto realize. 22 One proposal would restrict the allocation of pre-contribu-tion loss to the contributing partner.23 Another would make mandatorydownward basis adjustments by the transferee on a transfer of a partner-ship interest and by the remaining partners on a liquidation of an interestwhen there is a substantial built-in loss. 24 The latter proposal is the moreartful solution. It is a step in the general direction of making mandatorythe basis adjustments on distributions that are now elective, somethingthat several commentators have advocated.25

A more obscure 1999 change in the regulations on elective basis adjust-ments26 is more telling evidence of the change in thinking. A change in aconceptual system in the law makes the greatest difference on technicalor peripheral issues where the proper action is not clear cut. The rules onelective basis adjustments come into play when a partner disposes of hisinterest recognizing gain or loss. 27 They give the successor a cost basis inthe partnership's assets equal to his cost basis in the interest in order toavoid duplicating gain or loss recognized by his predecessor. Under theold way of thinking, the idea was to correct the discrepancy between thesuccessor's basis in his interest (called outside basis) and the aggregatebasis of partnership assets (called inside basis). This meant that adjust-ments in the basis of assets could be made in only one direction towardsoutside basis. The new way of thinking is that the adjustments give thesuccessor credit for deferred tax amounts recognized by his predecessor.Adjustments are by asset and can be plus or minus. In effect, the prede-cessor's deferred tax amount tags are stamped "recognized" and given tothe successor to present when an asset is sold or used up.

A 1997 amendment to the rules for allocating basis to distributed assetsalso is indicative of the change in thinking. The rules for allocating basisto distributed assets come into play when a partner takes assets for hisinterest without recognizing gain or loss. The idea is to embed this gainor loss in the assets he takes to be recognized at a future time. Under the

22. Amending § 737 to cover pre-contribution loss as well as pre-contribution gaindoes not do the trick by itself because inside basis adjustments are not mandatory.

23. H.R. 5095, 107th Cong. § 106(a) (2002) (amending I.R.C. § 704(c)).24. H.R. 5095, 107th Cong. § 106(b) (2002) (amending I.R.C. § 743), H.R. 5095, 107th

Cong. § 106(c) (2002) (amending I.R.C. § 734).25. William D. Andrews, Inside Basis Adjustments and Hot Asset Exchanges in Part-

nership Distributions, 47 TAx L. REV. 3, 23 (1991); Noel B. Cunningham, Tending the SickRose, 47 TAx L. REV. 77, 82-83 (1991); see also Karen C. Burke, Partnership Distributions:Options for Reform, 3 FLA. TAX REV. 677 (1998).

26. Treas. Reg. § 1.755-1 (as amended by T.D. 8847 (Dec. 14, 1999)). William An-drews made the case for this change in Andrews, supra note 25, at 23. This was endorsedby Cunningham, supra note 25, at 84-89.

27. This can be by a sale of the interest or by taking cash or trade securities in liquida-tion of an interest. The passing of an interest on death is the other case. The basis adjust-ment gives the successor in interest the benefit of the basis step up at death.

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new way of thinking, this is done by adding up the retiring partner's de-ferred tax amounts for ordinary and capital assets and then dispersing thenet amount among the distributed assets in a way that preserves the char-acter of gain and loss (so a net capital gain must go to capital assets) andevens out the resulting embedded gain (or loss) across assets to minimizethe opportunities for "cherry-picking" by spreading the gain (or loss)across assets. The 1997 amendments do essentially this albeit by a some-what circuitous route. The old way of thinking conceived of the problemas a matter of adjusting asset basis to equal outside basis. It allocated abasis increase among assets in proportion to their respective bases, whichcould enlarge embedded gains and losses when gain and loss assets weredistributed together.2 8 Once one understands that the point of the exer-cise is to carry over deferred gain or loss, this seems perverse.

The handling of distributions that alter interests in ordinary incomeand capital assets is some of the most striking evidence of the old way ofthinking. The new way of thinking has not yet had much effect in thisarea. A 1999 amendment to the § 751 regulations is a small first step inthe direction of the new thinking. The amendment changes how ordinaryincome is determined on a sale of a partnership interest. Under the oldway there was a deemed distribution of ordinary partnership assets to thetransferee followed by an asset sale. This step was necessary under theold way of thinking to determine how much of the gain on the sale of theinterest was attributable to ordinary income assets. The new way is to askhow much ordinary income would have been allocated to the transfereehad the partnership sold all of its assets. 29 In other words, tote up theordinary income on the transferee's tags. This is a fairly modest simplifi-cation with a minor substantive impact.30 More significant changes thatwould significantly simplify preventing character shifts are possible in thenew system. I will come back to this.

The system of capital accounts analysis also has been useful in design-ing rules to prevent people from taking undue advantage of partnerships

28. Here is an example. A retires from ABCD partnership taking 2 parcels of land inliquidation of his interest. Parcel 1 has a basis of $60 and a value of $100. Parcel 2 has abasis of $40 and a value of $20. A's basis in his interest is $70. He has a net capital gain of$50 on all partnership assets. Under the old rules, there is a $30 basis decrease on thedistribution two-thirds ($20) of which is allocated to parcel 1 and one-third ($10) of whichis allocated to parcel 2. A is left with a net capital gain of $50 between parcels 1 and 2composed of $60 gain on parcel 1 and a $10 loss on parcel 2.

Under the new way of thinking the $50 deferred tax gain ought to be divided across the2 parcels in a way that minimizes the opportunity for cherry picking. Section 732(c) doesthis in two steps. First, $20 of the basis decrease is allocated to parcel 2 to eliminate thebuilt-in loss. Second, the remaining $20 basis decrease is apportioned between parcels 1and 2 according to their respective basis ($60 and $20) so three-fourths ($7.50) goes toparcel 1 and one-fourth ($2.50) goes to parcel 2. A is left holding parcel 1 with a basis of$52.50 and value of $100 and parcel 2 with a basis of $17.50 and a value of $20.

29. Treas. Reg. § 1.751-1(a)(2) (as amended in 1999).30. Estate lawyers are in a tizzy because they can no longer rely on § 732(d) to make

basis adjustments to avoid ordinary income on a sale of an interest. See James E. Maule &Lisa Marie Starczewski, IRS Hot Asset Reg Re-Tuning Falls Flat, Causing Sharp Pain forPartner Estates, 94 TAX NOTES 751 (2002), 2002 TAX NoTEs TODAY 29-28 (2002).

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to exchange assets tax free, another problem that bedeviled the partner-ship area in the 1980s and 1990s. 31 Section 704(c)(1)(B), enacted in 1989,and § 737, enacted in 1992, require a partner who contributes a gain assetto a partnership to recognize pre-contribution gain should he or the assetgo separate ways-the partner by liquidating his interest, the asset bybeing distributed to another partner 32-within a five-year period. Thiswas extended to seven years in 1997. The system also underlies an excep-tion to § 731(c), enacted in 1994, which limits the power to exchange as-sets tax-free through a partnership by treating marketable securities ascash. The exception defers tax on the distributee's own share of gain on adistributed security. 33

The system of capital accounts analysis provides the information to taxthe correct person on the correct amount when an asset is exchangedthrough a partnership. However, it does not resolve when is the correcttime to recognize a deferred tax amount. It treats a contribution of anasset to a partnership as a sale for economic or book purposes while de-ferring recognition of the gain or loss for tax purposes to a later, unspeci-fied event. 34 Some later recognition events are settled. When an asset issold or used up, deferred tax amounts associated with it are recognized. 35

When a partner sells his interest, his gain or loss is recognized and theslate is wiped clear.36 This also happens when a partner completely liqui-dates his interest taking cash 37 and when a partner completely liquidates

31. I.R.C. § 707(a)(2)(B) (1984), implementing regulations adopted in 1992, Treas.Reg. § 1.707-3, 4, 5, 6, 8, and 9, tackle the problem by saying that transfers to and from apartnership that look too much like a sale are taxed as a sale.

32. A partner and an asset might also separate by the partner selling his interest or thepartnership selling the asset. Section 704(c) ensures the contributing partner is taxed onpre-contribution gain in the latter case. It has no time limit. No special rule is necessary tocover the former case.

33. I.R.C. § 731(c)(3)(B) (1986). This result is reached under the statute through atwisted route. The amount of the distribution (normally the market value of the security)is reduced by the excess of (1) the gain that would be allocated to the distributee if allshares of a like kind were sold by the partnership immediately prior to the distribution,over (2) the gain that would be allocated to the distributee if all the remaining shares oflike kind were sold by the partnership immediately after the distribution. This shouldequal the gain that would have been allocated to the distributee had the distributed secur-ity been sold.

34. The same holds true for a contribution or a distribution that alters a person's inter-est in future gain or loss on an asset already in a partnership. Capital accounts analysistreats this as a sale of the asset that requires an accounting of current gain or loss foreconomic or book purposes, but it defers recognition of the economic gain or loss for taxpurposes to a later, unspecified event.

35. I.R.C. § 704(c) and the regulations.36. This statement is a bit of an over-simplification. The seller recognizes capital gain

or loss under § 741. Section 751(a) picks up ordinary income. There is no effort to break-out other items of deferred gain or loss-such as ordinary loss or odd bits of capital gainsubject to special rates-that would make the sale of an interest precisely equivalent to anasset sale. If a § 754 election is in effect these finer adjustments will have to be made togive the buyer proper credit. If partners elect to make the effort to get it right on thebuyer's side, then it is hard to see a reason why the same should not be done on the seller'sside.

37. Again this is a bit of a simplification. A partner who liquidates his interest for cashrecognizes capital gain or loss under § 731. Section 751(b) tries to ensure that deferred

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his interest taking marketable securities (except for deferred tax amountsassociated with the securities he takes in the liquidation). Assuming§ 751 does not come into play, as the law stands now, deferred taxamounts are not recognized if a partner takes cash or marketable securi-ties in partial liquidation of his interest until the value of what he takesexceeds his basis in his interest. Further, deferred tax amounts are notrecognized if a partner completely liquidates his interest taking assets inwhich his deferred gain or loss can be embedded.

II. EXTENDING THE SYSTEM

Extending the system of capital accounts analysis can help solve twopersistent problems in partnership tax. What follows assumes two otherchanges in the law. One change is a requirement that assets be revaluedand capital accounts adjusted whenever there is a change in sharing ra-tios. The § 704(b) regulations push people to make these adjustments ona non-pro rata contribution or distribution.38 This should becomemandatory and the rule should be extended to cover modifications of apartnership agreement that alter sharing ratios. The other change is thatbasis adjustments on distributions under § 734(b) that now are electiveshould be made mandatory.

A. PREVENTING CHARACTER SHIFTS ON DISTRIBUTIONS

Capital accounts analysis can improve and simplify the rules that pre-vent character shifts on distributions. The problem arises when a partner-ship with a mix of capital and ordinary assets distributes an asset of onetype to a partner in exchange for his interest in an asset of another type.This is dealt with by § 751(b), which comes into play when a partner re-ceives ordinary assets in a distribution in exchange for his interest in capi-tal assets or vice versa. This triggers a deemed distribution to the partnerof assets of the relinquished character, which is followed by a sale ofthose assets back to the partnership in return for equal value of assets ofthe acquired character.

Others have shown how the system of capital accounts analysis can beused to improve and simplify this system.39 First, the statute gets it wrongright off the bat by asking whether a distribution alters a partner's rela-tive holdings of capital and ordinary assets. The proper question iswhether a corrective measure is necessary so that a distribution does re-sult in a character shift. The following example illustrates:

amounts that are ordinary income are broken out but the current statute does a poor job.There is no effort to break out ordinary loss or odd bits of capital gain. Again if a § 754election is in effect these finer adjustments will have to be made to give the other partnersproper credit.

38. See supra note 19.39. These changes were proposed by Andrews and endorsed by Cunningham in 1991.

Andrews, supra note 25, at 37; Cunningham, supra note 25, at 89-93. See also Karen C.Burke, Partnership Distributions: Options for Reform, 3 FLA. TAX REv. 677, 704 (1998).

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Example: AB Partnership has two capital assets-Cl (value $100,basis $60) and C2 (value $100, basis $100)-and two ordinary as-sets-O1 (value $100, basis $100) and 02 (value $100, basis $60). Aand B each have a $160 basis in their interest and a $40 deferredgain, which is half capital (on C]) and half ordinary (on 02). Atakes C1 and 01 in liquidation of his interest and B takes C2 and 02.There is no deemed exchange under § 751 because each partnertakes $100 in value of capital assets and $100 in value of ordinaryassets. There is a shift of $20 ordinary income and capital gain be-tween A and B.

This is more evidence of the baleful effects of the old way of thinking.Today we understand that the statutory trigger misses the point of theexercise, which is to ensure that a partner does not escape ordinary in-come tagged to him.

The system of capital accounts analysis can simplify the rules that pre-vent character shifts. I use a loaded example, taken from Revenue Rul-ing 84-102,40 in which the application of § 751(b) is particularlycomplicated and utterly pointless in light of the new thinking. The rulingaddresses a case where a partnership that has an unrealized receivableadmits a new partner who assumes a share of partnership debt. The newpartner's assumption of debt results in a deemed distribution of cash tothe old partners, which brings into play § 751(b). The old partners aretreated as if they sold a share of the receivable in return for cash.

Example: A, B, and C are equal partners in a partnership with netassets worth $75x, including a $40x unrealized receivable, and liabili-ties in the amount $100x. D contributes $25x for a one-quarter inter-est and assumes one quarter of the liabilities ($25x) resulting in adeemed distribution of $8.33x each to A, B, and C. Of the $25xdeemed distribution, $10x is attributable to the receivable. A, B, andC each have $3.33x ordinary income. The partnership has a $10xbasis in the receivable.

Under the § 704(b) regulations, the remaining $30x ordinary income onthe receivable must be allocated to A, B, and C when it is collected if thereceivable is valued on the admission of D. This suggests a way to sim-plify the law. Eliminate the deemed exchange of a share of the receivableon D's assumption of debt and rely on the § 704(b) regulations to allocatethe entire $40x ordinary income to A, B, and C. This is precisely what wewould do had D contributed $50x cash to the partnership rather thancontributing $25x and assuming $25x of debt.

Taking this a considerable step further, § 751(b) might be replaced en-tirely by a rule requiring a partner to recognize a deferred tax amount if itcould not be attached to an asset of appropriate character after a distribu-tion. For example, if a partner takes high-basis inventory in a distributiongiving up an interest in zero-basis receivables, then we would decrease hisbasis in the inventory and increase the remaining partner's basis in the

40. Rev. Rul. 84-102, 1984-2 C.B. 119 (1984).

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receivables to preserve everyone's tax position. If effect, deferred taxamount tags are moved from one asset to another. If there is no appro-priate asset on which to stick a tag, then the amount on the tag is recog-nized. This rule coupled with a rule that requires asset revaluations andcapital account adjustments on contributions and distributions would pre-vent character shifts better than § 751(b) does presently. It is more sim-ple because it does not require constructing a deemed distribution and adeemed exchange. It also simplifies allocating basis to distributed assets.

This more considerable step raises an issue that is not unique to distri-butions that alter interests in ordinary assets. This change gives partnersmore leeway to trade ordinary assets among themselves without recogniz-ing gain or loss. It is difficult to justify § 751(b) as a limitation on assettrading among partners. Current law permits tax-free trading of ordinaryassets if capital and ordinary assets of equal value are on both sides of thetrade, though this could be chalked up to a glitch in the statute. Moreimportantly, current law permits tax-free trading of capital assets (otherthan publicly traded securities) among partners so long as the assets donot bear pre-contribution gain or loss that is less than seven-years old.Tax-free trading of capital assets generally is more worrisome than tax-free trading of ordinary assets because capital assets tend to have longerlives and people tend to have more control over recognition of capitalgain and loss.

B. TAXING SERVICE PARTNERS

Current law does a poor job of identifying when returns from a part-nership represent compensation for services. This is important becausecompensation is taxed at higher rates and is subject to employment taxeson top.41 Tax law also generally makes it difficult to defer tax on com-pensation once wealth is in an employee's hands. A deal I heard aboutover a decade ago is an extreme example of how partnerships can be usedto beat the system. A movie star is given a profits interest in a partner-ship that will produce the film in which he will star with an agreementthat the partnership will buy a personal jet and distribute the jet to him inpartial satisfaction of his right to profits. The Treasury threw in the towelon trying to tax the receipt of a profits interest in 1993.42 If the star waitsuntil profits are earned by the partnership, then he will be taxed on theearnings. But he can avoid tax by liquidating his interest and taking thejet for his right to future profits. He ends up with a private jet as tax-freecompensation.

41. Partners are subject to the self-employment tax, which is currently at a rate of15.3%. This consists of two taxes, the OASDI tax of 12.4%, which disappears at around$87,000 of income (the ceiling is indexed for inflation), and the HI tax of 2.9%, which hasno ceiling. Under § 1402, the self-employment tax is assessed on an individual's "distribu-tive share (whether or not distributed) of income or loss described in § 702(a)(8) from anytrade or business carried on by a partnership of which he is a member." Rents, dividends,interest, and capital gains are excluded.

42. Rev. Proc. 93-27, 1993-2 C.B. 343 (1993).

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A more prosaic problem arises when a person contributes an idea (orother intangible property) and a commitment to work to bring the idea tofruition to a partnership in which others contribute capital.43 This bringsinto play a rule that if other partners give up a right to capital they con-tribute to compensate a partner for services, what they give up is compen-sation to the service partner. 44 The problem is to determine how much ofthe value of the interest the idea-man receives is attributable to the prop-erty and how much is attributable to the services.

The system of capital accounts analysis helps solve both problems. Weshould treat an addition to the capital account of a person who providesservices to a partnership and has no capital invested in the partnership ascompensation. This catches the film star because the distribution of thejet must be preceded by an addition to his capital account either throughan allocation of earned income or through a revaluation of partnershipassets.

The problem of valuing contributed property can be dealt with in manycases by a presumption that the property is worth the amount credited tothe contributor's capital account. This presumption should be conclusiveif capital accounts are meaningful, as they are if gains and losses are allo-cated based on capital account balances, or if a partner has the right toliquidate a partnership and force a sale of its assets. I also would respectasset valuation if the contributing partner faces a risk of civil liability toother partners if a statement of value is false or a lie. While this would bean improvement over the status quo, it is far from a perfect solution be-cause capital accounts may not be a true measure of a partner's economicinterest in a partnership. This problem is foundational.

III. ANOMALIES IN THE SYSTEM

The usual criticism of the system of capital accounts analysis is that itweakly regulates special allocations.45 The system can be gamed by off-setting allocations. For example, a high-tax bracket partner is allocated aloss that will be offset by a later allocation of a gain. Such offsettingallocations are regulated by an anti-abuse standards that ask whether theallocations have a sufficient economic effect.46

43. United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984), is a leading case. Staffordcontributed a letter of intent that promised financing and a lease for a real estate projectand a commitment to manage the project in order to raise around $2 million capital. Thecase is important for the holding that an intangible right that may not be legally enforcea-ble can be property under § 721. The case was remanded so the lower court could deter-mine how much of the value of the interest Stafford received was attributable to theproperty.

44. Treas. Reg. § 1.721-1(b)(1) (as amended in 1996). Johnston v. Comm'r, 69 TCM(CCH) 2283 (1995).

45. Mark P. Gergen, Reforming Subchapter K: Special Allocations, 46 TAX L. REV. 1(1990); Yin, supra note 4; Lokken, supra note 2.

46. These, of course, are found in the substantiality requirement. Treas. Reg. § 1.704-1(b)(2)(iii) (as amended in 1999).

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Implicit in the worry about offsetting allocations is an awareness thatcapital accounts may not be a good indicator of a partner's economic in-terest in a partnership. A partner who is allocated a tax loss suffers nocorresponding economic loss if he is assured an offsetting allocation of atax gain. Meanwhile he is able to defer tax on income. Special alloca-tions are not unique in having this property. It is well-known that guar-anteed payments can be used to make payoffs that differ from capitalaccount balances. This part explains how options (along with other sideagreements) and discounts in the value of a partnership interest have thesame property. We are just beginning to grapple with the implications ofoptions and discounts. How the government will respond to the chal-lenges they pose is not yet clear. At best, the response to discounts andoptions will erode the system's conceptual elegance and require morecomplex rules. Options and discounts may turn out to be the death of thecurrent system. The proliferation of ways or justifications for makingpayoffs from a partnership that differ from capital accounts makes it diffi-cult to trust how partners value assets, which is the linchpin of the systemof capital accounts analysis.

A. OPTIONS

Capital accounts analysis is not a closed system. Tax law must recog-nize side agreements that make payoffs from a partnership independentof capital accounts. Side agreements are necessary if a case as basic asUnited States v. Basye is to fit within the system.47 The case is a staple inmany partnership tax courses because it is a rare Supreme Court opinionin the area. It illustrates the unremarkable proposition that partnershipincome flows through to the partners. The issue was thought worth argu-ing about in Basye because income earned by a partnership of physicianswas placed in to a trust and was subject to forfeiture by a partner-physi-cian if he quit prematurely or violated a covenant not to compete.

Today Basye raises the question of how to do the same deal within theconstraints of the § 704(b) regulations, which do not allow for forfeitureof a capital account. The answer is that forfeiture may be provided for inthe partnership agreement by a guaranteed payment from a defaulter tothe other partners. It also may be provided for outside the partnershipagreement by a side agreement requiring a defaulter to surrender hispartnership interest to the other partners. The guaranteed payment is thebetter solution because it gets the character of income, and loss correct-the defaulter has an ordinary deduction to offset earlier ordinary incomeand the other partners have ordinary income. But neither capital ac-

47. United States v. Basye, 410 U.S. 441 (1973). The case still appears in McDANIEL,MCMAHON & SIMMONS, FEDERAL INCOME TAXATION OF PARTNERSHIPS AND S CORPORA-TIONS 72 (3d ed. 1999); POSTELWAITE & BIRKELAND, THE TAXATION OF SMALL BUSINESSENTERPRISE 193 (1997); and COVEN, PERONI & PUGH, TAXATION OF BUSINESS ENTER-

PRISE 852 (2d ed. 2002).

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counts analysis nor any other rule in subchapter K compels this particularsolution.

There has been much discussion of how to handle partnership optionsin the last few years.4 8 A variation on our old friend the KLM examplecan be used to get some of the issues on the table.

Example: K and L each invest $9,500 in KL Partnership. M invests$1,000 in return for an option to acquire a one-third partnership in-terest by a further contribution of $16,000. The partnership investsthe $20,000 in securities. When the securities are worth $50,000, Mexercises his option and acquires a one-third interest by contributing$16,000. M's one-third interest is worth $22,000. His investment inthe interest is $17,000.

Whether anyone should recognize gain on the grant or exercise of anon-compensatory option is mostly a non-issue. 49 The answer is no underthe general rules on options, and it is no under the general rules of sub-chapter K. The option could be structured as a partnership interest fromthe outset, giving M a right to a share in asset appreciation subject to anobligation to make a further capital contribution. It would be perverse tomake a special exception to these rules for partnership options.

How to account for this transaction within the system of capital ac-counts analysis also seems fairly clear. The Tax Section of the New YorkState Bar Association ("NYSBA") gives what is the logical answer if thegoal is to square capital accounts with the economics of the deal. BeforeM exercises the option, the partnership carries a $1,000 obligation to himon the capital and liabilities side of the ledger. When M exercises theoption he is given a capital account of $22,000 and tagged with $5,000 ofthe $30,000 deferred gain on the securities. This is what would be donewere the option structured as a partnership interest from the outset. Bythe same logic, if the partnership has multiple assets of different types,some gainers and some losers, then M should be tagged with a one-sixthshare of the deferred gain and loss on each asset to yield a net gain of$5,000.50 These questions can be answered within the system of capital

48. The best thing written on the subject is a report by the Tax Section of the NewYork State Bar Association, Report on the Taxation of Partnership Options and Converti-ble Securities (Jan. 31, 2002), reprinted in 2002 TAx NOTES TODAY 21-24 (2002) [hereinaf-ter NYSBA Report]. Also good and engagingly cynical is Lee Sheppard, The Fairies, TheMagic Circle, and Partnership Options, 90 TAX NorEs 721 (2001).

49. The one sticking point under current law is the treatment of the other partners onthe exercise of an option. Generally, the writer of an option is taxed on its exercise be-cause he disposes of the underlying property. The exercise of a partnership option dilutesthe interests of the original partners. Typically, the value of what they seem to give upupon exercise will exceed the price paid by the option holder. In truth, the original part-ners give up and get nothing on exercise for the option holder always had a claim on assetappreciation. This makes it a bit awkward to tax the original partners on exercise of theoption. The effect of doing so is to require them to recognize some of their share of gainon asset appreciation.

50. Regulations recently issued to handle discounts in the value of an interest whenbasis adjustments are made upon the exchange of an interest take a very different ap-proach. See infra text accompanying note 58.

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account analysis because M's option can be recast as a partnershipinterest.

This scratches the surface of the issues raised by options. Particularlytroublesome is the question of what to do if KL Partnership sells thesecurities before M exercises the option. By the logic of the precedinganalysis some of the gain on the securities should be allocated to M, as itwould be were the option structured as a partnership interest. TheNYSBA argues that an option holder should not be treated as a partneruntil he exercises the option. This opens the door to investment partner-ships that combine tax-exempt persons as partners and tax-paying per-sons as option-holders to allow security trading without anyone payingtax on the gain. The NYSBA proposes to close this door with an anti-abuse rule. 51 I am skeptical that this will do. Their answer allows stake-holders in a partnership to opt out of pass-through taxation as a matter ofgeneral principle. That other partners will bear the tax dodged by thosewho opt out by taking an option in a partnership is little comfort becausethe world is full of potential tax-indifferent partners.

While the position of the NYSBA on this issue is difficult to accept, theother answer, which is to treat the holder of an unexercised option as apartner, grounds in a way of thinking that is inimical to the system ofcapital accounts analysis. The system of capital accounts analysis trans-lates an economic interest in a partnership into an interest in partnershipassets in order to determine who should be tagged with deferred gain orloss. This is accomplished by asking how gain and loss would be allocatedupon a hypothetical asset sale and liquidation of a partnership. 52 Bring-ing unexercised options within the system moves in the direction of asystem that tags a person with deferred gain or loss based upon the valueof his claim on the pot, rather than what he would receive in a hypotheti-cal sale and liquidation at that time. This may seem a small thing, but ahypothetical sale and liquidation has been the touchstone for deriving apartner's deferred gain or loss from the partnership agreement. TheNYSBA countenances this in a context where it seems a small and obvi-ous step to take. They recommend in the case of the admission of a newpartner who pays a discounted price for his interest because of an extantunexercised option that the option holder be tagged with gain or loss forbook purposes (with tax consequences to follow if he exercises the op-tion).53 The logic behind the answer is impeccable because to do other-wise would require crediting the new partner with a capital accountgreater than the amount of his contribution.

This may seem a small step, but the decision to abandon the touchstoneof a hypothetical sale and liquidation has momentous possibilities. Say

51. NYSBA Report, supra note 48, Part V-C.52. Upon a contribution or distribution the hypothetical sale and liquidation occurs

immediately before the contribution or distribution. In the case of an option to makecapital accounts conform with the economics the hypothetical sale and liquidation mustoccur immediately after exercise.

53. NYSBA Report, supra note 48, Appendix One ex. 4.

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we decide to tag an option-holder with book gain when he clearly seemsthe economic beneficiary. Why not go one step further than the NYSBAand tax him on that gain when it is recognized by the partnership, even ifhe has not yet exercised the option? It is fairly easy to make a case forimposing this regime on traded options that have a readily determinedmarket value. But why stop with traded options or, indeed, why stopwith options? A case for similar measures can be made whenever con-tractual mechanisms are in place that make payoffs from a partnershipmaterially differ from capital accounts.

There also will be vexing administrative problems. The allocation ofbook gain (and at some point tax gain) to an option holder based on thevalue of the option involves a great deal of discretion when the value of apartnership's assets and/or the value of an option is indeterminate. Therealso will be vexing technical issues in translating an interest in a partner-ship into an interest in assets. To give you an idea of the sort of technicalproblems that arise I turn to another phenomenon that we have just be-gun to grapple with.

B. DISCOUNTS

The value of a partnership interest will not equal the value of a part-ner's interest in partnership assets when a partner cannot realize the assetvalue by forcing a liquidation of the partnership or by selling his inter-est. 54 Discounts in the value of a partnership interest due to restrictionson liquidity or minority status have become bread and butter to the estatetax bar, who rely on discounts to reduce the value of an estate, sometimesby 50 percent or more, when wealth is passed through a family partner-ship.55 If the government ever gets serious about trying to tax compensa-tory grants of partnership interests, it likely will face similar arguments.

It seems fairly clear how discounts should be handled in principlewithin the system of capital accounts analysis if asset value is known. As-sume KL Partnership has marketable securities priced at $50,000 with abasis of $20,000. It admits M as an equal one-third partner for a contribu-tion of $16,000.56 M buys in at a discount because he has a minority inter-est that he cannot sell. The question is how to handle the $30,000 built-ingain on the securities. Under § 704(b) regulations, K and L are taggedwith the full amount of this gain. But the partners agree that M is enti-tled to one-third of the value of partnership assets upon liquidation,

54. I focus on discounts because they are more common. Premiums present similarproblems.

55. In a typical family limited partnership, the older generation transfers assets to alimited partnership. The older generation makes gifts of partial interests in the partnershipwhile they live, and the remaining interest passes to the younger generation at death. Theinterests conveyed during life and at death are discounted in value as minority interestsand because of contractual restrictions on liquidity and the like. There has been muchlitigation and much written on the viability of a family limited partnership as an estate-planning device and the legal risks of steep valuation discounts.

56. Except for the amount of C's contribution, this is example four from the old§ 704(b) regulations.

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which would be $22,000 in an immediate liquidation. The purpose of thecapital account rules is to describe the economics-they are not meant tobe a strait jacket. To describe the economics, M should get a $22,000capital account. The natural inference is that M should be tagged with$6,000 of the deferred tax gain on the securities because that slice of thevalue is his.

Tagging M with the appropriate amount of deferred gain or loss onparticular partnership assets can be quite cumbersome when a partner-ship has multiple assets. Treasury has taken two cracks at this in regula-tions issued under §,755 that apply to elective basis adjustments upon theacquisition of an interest. The regulations would apply if M purchased orinherited his interest from K or L. The following brief description ismeant to give you just a taste of what is required. In order to do basisadjustments, you must determine asset value (based on an asset's hypo-thetical sale price) and interest value and then decide how to allocate thedifference across assets. Regulations issued in 1999 use a nine-stepmethod. 57 The end result of the nine steps is to allocate a downwardadjustment from asset value first to capital assets in proportion to theirmarket value (defined as the hypothetical sale price) and then to ordinaryassets if capital assets cannot absorb the full amount of the adjustment.On the heel of these regulations, in the year 2000, came proposed regula-tions58 that divide assets into five classes-cash and cash equivalents,most ordinary assets, tangible capital assets, intangible assets other thangoodwill, and goodwill. Under the proposed regulations, deemed assetvalue is derived from the value of an interest. Interest value is allocatedfirst to cash and cash equivalents, then to tangible ordinary assets (basedon their hypothetical sale price), and so on down the ladder until interestvalue is exhausted. The end result is similar to the current regulations inthat capital assets absorb a discount before tangible ordinary assets. Adifference is that intangible assets, including certain ordinary income in-tangible assets, 59 absorb a discount before capital assets.

I expect these regulations are not the final word on handling basis ad-justments when an interest is sold or inherited with a discount in value.The regulations make it possible for ordinary income to escape tax. Theworking assumption of the regulations is that the acquirer of an intereststarts with a clean slate with a basis in assets equal to market value.Downward adjustments because of a discount create built-in gain thatgoes first to capital assets. This creates the possibility of a partner purg-

57. Treas. Reg. § 1.755-1(b). For a longer explanation and an example, see M. CARR

FERGUSON ET. AL., FEDERAL INCOME TAXATION OF ESTATES TRUSTS AND BENEFICIARIES

§§ 4.03[B][2], 4.03[B][4] (3d ed. 1998 & Supp. 2002).58. Prop. Treas. Reg. § 1.755-2(b); 65 Fed. Reg. 17829 (Apr. 5, 2000). The proposed

regulations cover only adjustments under § 743 upon the transfer of an interest. The pre-amble explains three different methods that the Treasury is considering for handling basisadjustments on distributions. See 65 Fed. Reg. 17829; 2000 TAX NOTES TODAY 69-81(2000).

59. Prop. Treas. Reg. § 1.755-2(b)(i)(B), 65 Fed. Reg. 17829 (Apr. 6, 2000). To be inthis class an asset must be both a § 197 intangible and an unrealized receivable.

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ing an interest of potential ordinary income by selling the interest to arelated person at a discount. This might be solved at the seller's end byadopting parallel rules for allocating the purchase price under § 751.60

Although this solution would permit ordinary income not in the nature ofincome in respect of a decedent to escape tax when an interest isinherited.

When M buys into a partnership at a discount by making a contribu-tion, similar questions arise about how to allocate his contribution to as-sets or how to tag him with appropriate amounts of built-in gain or loss.This is very much like the problem of tagging an option-holder with gainattributable to his option. One possibility is to tag M with a share of thebuilt-in gain and loss on all partnership assets in a way that leaves himwith a net gain equal to the difference between what he paid for his inter-est and his share of the value of partnership assets. This approach makesintuitive sense when M acquires an interest at a discount through exerciseof an option because it is how we handle the parallel case in which Mtakes a profits interest that is contingent on his making a further capitalcontribution. M is in a similar position if he buys into a partnership at adiscount that is a result of minority status or liquidity restriction, but itseems odd in this situation to tag M with a share of built-in loss.

The § 755 regulations take a radically different approach. They start bygiving M a basis in assets equal to their market value. This is then re-duced to absorb the discount, which has the effect of tagging M with ashare of built-in gain (but never a share of built-in loss). Under the 1999regulations, capital assets absorb the discount before any ordinary assetsare discounted. Under the 2000 proposed regulations, intangible assets,then capital assets, then ordinary assets, and finally cash and cashequivalents absorb the discount. An argument for the approach in theproposed regulations is that, in an acquisition of a pool of assets of specu-lative value, basis should go first to the assets with the least speculativevalue in order to at least get acquisition cost right with respect to thoseassets.

Plausible arguments can be made for either approach. The suggestedapproach for handling the exercise of an option is consistent with thesystem of capital accounts analysis in that the objective is to tag stake-holders in a partnership with deferred gain and loss that is attributable totheir interest. But this approach requires accurate valuation of a stake-holder's interest and partnership assets. The approach in the § 755 pro-posed regulations is skeptical about asset valuation. It takes the one hardfact in a cash acquisition-the purchase price-and doles it out as basis tocash, then to tangible receivables, then to tangible assets, and finally tointangibles. The idea is to assign basis to hard assets with the most read-ily measured value.

60. The issue of discounts was not addressed when § 1.751-1(a) was amended in 1999.

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Perhaps we will want to use these two approaches selectively. This, ofcourse, makes the system more complex and creates line-drawingproblems. If your mind is not yet reeling over the possibilities, let methrow in one more wrinkle. To justify tagging an option-holder with bookgain, the NYSBA gives as an example the case where N buys into KLPartnership at a discount under book value because of an outstandingoption held by M. The NYSBA reasons that M must be tagged with bookgain in this situation for, if he is not, then N must be given a capital ac-count greater than his contribution, which misdescribes the economics ofthe deal. But N could also be given a capital account greater than whathe paid for his interest because he paid a discounted price for his interest.This means that if we have different systems for handling basis or bookadjustments on discounts and options, people may choose between thesystems by attributing the discrepancy between what N pays for his inter-est and the book value of partnership assets to one or the other source orto both.

C. FISHY VALUATION

Asset valuation is the Achilles heel of the system of capital accountsanalysis. People can defeat the system by misstating the value of an asset.For example, property can be exchanged through a partnership withoutrecognizing gain under §§ 704(c)(1)(2) and 737 by valuing it at basis tohide pre-contribution gain. The system opens the door to new abuses ifpeople are willing to lie about asset value. For example, a tax exemptentity may overstate the value of depreciable property it contributes to apartnership to create depreciation deductions for other partners at nocost to itself.61

Regrettably, we cannot depend upon people to be honest in dealingwith the taxman.62 In the partnership area, we hope that partners willpolice each other. More precisely, we hope that partners will insist thatfair values be placed on what is put into and taken out of a partnershipbecause this affects their claim on the pot. This might seem a safe bet inbusiness partnerships, particularly if they involve more than a few peopleor they involve firms that act through agents. Few businessmen will trustan informal, undocumented side agreement that a deal is radically differ-ent than what the paperwork says.

But special allocations, guaranteed payments, options (and other sideagreements), and valuation discounts and premiums can be used to beat

61. This could happen under the remedial allocation method. Treas. Reg. § 1.704-3(d)(1) (as amended in 1997). The method creates depreciation deductions to the non-contributing partner to eliminate a book-tax disparity and an equal amount of gain thecontributing partner. The regulations temper the incentive to do this by treating value inexcess of basis as a new asset put in service on the date of the contribution.

62. Leandra Lederman tells me that the celebrated high rate of self-compliance byAmericans in paying taxes is misleading. The rate combines compliance in paying taxes onwages-where evasion is quite difficult-with compliance in other areas. Compliance ismuch lower, below 50 percent, in areas where we depend upon honesty.

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the system through mis-valuation with contractual security.63 For exam-ple, a person may under-value an asset he contributes at an amount equalto basis to avoid the rules on pre-contribution gain and cover his lossfrom the under-valuation by taking an in-the-money option on a partner-ship interest or a partnership asset. Or he could cover his loss by gettinga capital account greater than the value of his contribution and justify thisby a discount in the value of the interest. Or he could cover his loss witha guaranteed payment. Or he could cover his loss with a specialallocation.

One thought is to deter people from misvaluing assets through disclo-sure requirements. 64 However, the number of disclosed transactionswould be so large that the threat of scrutiny by a field agent would not becredible. Disclosure would have to include partnership agreements withspecial allocations, guaranteed payments on capital plus such common-place arrangements as buy-back agreements, and forfeiture provisions.Disclosure might be limited to partnerships with at least one partner whois not a U.S. individual in the event of significant non-cash contributionor distribution. But I expect this still will be a daunting number.65

IV. CONCLUSION

The system of capital accounts analysis elegantly solves many of theproblems that have beset subchapter K since its creation in its modernform in 1954. It is ironic that the immediate impetuous behind the crea-tion of the system was handling special allocations, for this is one of itsweaker points. The system excels at connecting partnership level andpartner level tax consequences as partners and assets come and go from apartnership, while preserving the general principle of nonrecognition.Anyone who has worked with the rules on basis adjustments and hot as-sets will appreciate that this is no small accomplishment. Most of theproblems of the day can be solved by extending the system. 66

In coming years we are likely to see new types of problems in the part-nership area that the system of capital accounts analysis is ill-suited to

63. These methods can also be used to try to beat the rules on special allocations. Apartnership may be used to strip interest and create a zero-coupon bond without imputedinterest by allocating all interest to a class of partners. A guaranteed payment is used towipe out the positive capital account balance of the interest class upon maturity of thebonds that the principal class will receive all the principal payments. For a fuller discussionof the stratagem, see Gergen, supra note 45, at 30-32.

64. Disclosure is used as a deterrent elsewhere in partnership tax. The real teeth ofthe disguised sale regulations are provisions that require partners to disclose transfers toand from a partnership if the transfers occur within two years of each other, unless thetransfers come within exceptions written to cover some ordinary and unproblematic distri-butions. Treas. Reg. §§ 1.707-3(c)(2), 1.707-5(a)(7)(ii), 1.707-6(c) (1992).

65. Excluding service partnerships still leaves a very large pool. Fewer than 1/4th ofpartnerships are in service industries. See ALAN ZEMPEL & TIM WHEELER, PARTNERSHIPRETURNS, 1999 (Fall 2001), at http//www.irs.gov/pub/irs-soi/99partnr.pdf (last visited Feb.1, 2003).

66. "Take therefore no thought for the morrow: for the morrow shall take thought forthe things of itself. Sufficient unto the day is the evil thereof." Matthew 6:34.

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solve. Tax lawyers have just begun to explore the ramifications of part-nership options. As the wheel goes round on family limited partnershipstax lawyers will learn how to work with discounts in valuing a partnershipinterest. Options and discounts put further pressure on what has alwaysbeen the weak point of the system of capital accounts analysis. Like spe-cial allocations and guaranteed payments, they break the relationship be-tween capital accounts and partnership economics. At best, respondingto options and discounts will make the system much more complex. Timewill tell whether these new anomalies will bring the system down.


THE END OF THE REVOLUTION IN PARTNERSHIP TAX?

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